Crash Course on Low Interest Rates
The first thing we learn about fixed income investing is that when bond yields go up, bond prices go down, and vice versa. And since the United States presidential election, bond yields have gone up as global markets have assessed the implications of the Trump presidency.
The markets were clearly surprised by the election outcome and have shifted gears to contemplate higher future inflation as a result of anticipated aggressive fiscal policy coming out of Washington.
This all makes perfect sense. If inflation is seen as being higher in the future, investors will demand more compensation to lend money via the bond market. Combine this with a U.S. Federal Reserve that is seen as more likely to raise interest rates, and — on the surface — it doesn’t paint a favourable backdrop for investing in fixed income.
But of course there is always more to the story.
Once we’ve completed our course in “Introductory Fixed Income” and moved on to Intermediate Fixed Income, we learn about the power of compounding interest. Simply put, higher rates result in lower bond prices, but more importantly, higher rates also result in higher rates. (This is more of an Advanced Fixed Income concept!)
The implication for mutual fund investors is that their bond holdings will now earn higher yields, leading to higher distributions. Investors reinvesting these distributions will be able to reinvest at higher yields, allowing them to benefit from the virtuous cycle of compounding interest at the new higher rate.
What I just described is intuitive, but probably not top-of-mind when rates are rising and bond returns are depressed. It’s a classic case of enduring short-term pain for long-term gain. In fact, long-term investors in bonds should welcome higher rates. As a rule of thumb, investors with time horizons longer than the durations of their bond holdings may be better off in the long-term with a rise in rates today.
The mantras of discipline and long-term investing are never more important than when market volatility jumps. Volatility is more commonly associated with stocks rather than the sleepy bond market, but the same principles apply. And given the interplay of price and yield, it’s compelling to continue to invest in fixed income and rebalance to long-term asset allocations when rates are rising. One thing we can be sure of is that the market will continue to interpret and adjust to what the global economy will look like during the Trump presidency and beyond, and there will be bouts of indigestion as new information is introduced.
When it comes to navigating uncertain times, stick with your plan, ignore the noise, and remember the long-term outcomes — courtesy of Intermediate Fixed Income.
Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.